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A return to reason.


In the wake of a decade of severe over-building, the real estate industry has finally come to grips with reality - the tremendous space demands of the last 15 years are over. There is now full recognition that the 78 million "baby boomers" are housed and employed. Because new space needs will be much lower in the 1990s, the focus is shifting to management of existing assets to accommodate the demands of a mature, affluent population.

Buildings are being better maintained than ever before. The U.S. real estate inventory is of historically high overall quality, but the typical property is now in much stronger financial hands than has been true for decades. Furthermore, the "junk real estate" has largely been identified, has been devalued for the most part, and is in the process of being demolished or transferred into capable operational hands.

As is often the case, the media has just come to understand the extent of the overbuilding of the latter 1980s and the implications of a large inventory of marginally usable buildings. However, the transfer of those properties from unstable financial institutions to a federal government agency is actually the conclusion of a long and most unfortunate period in American real estate lending and development. The "quick buck" people have been flushed out of the industry (though their actual bankruptcies are still being announced), and real estate is now being bought, sold and financed on a much sounder economic basis. In other words, despite dire press reports, the U.S. real estate industry has "bottomed out" and is well along the road toward economic health.

The situation is even more positive because: * Domestic and foreign institutional

ownership has grown dramatically

during the last 15 years, and especially

in the past decade. This

accounts for the remarkable stability

of the top 25 percent of the

American property inventory - the

so-called investment-grade buildings.

Institutional owners typically

carry low leverage, have a long-term

perspective, impose high

maintenance standards and employ

professional managers.

Ownership by institutional investors

has put a significant share of

the U.S. commercial real estate inventory

into strong, long-term

hands. As a result, prices are continuing

to rise for very good-quality,

well-located, well-tenanted and well-maintained

properties that are put

up for sale. This "good news" seems

to rarely make the front pages,

while the trials and tribulations in

the bottom 25 percent of the inventory

are constantly highlighted. * In 1990 and 1991, some of the most

experienced institutional investors

will acquire lesser-quality "problem"

properties, thereby moving more of

the inventory into capable hands.

For the most part, such purchases

will be concentrated on well-built

properties whose prior owners were

unable to invest the additional capital

needed to attract or retain

tenants. Very few institutional investors

will be buying properties

repossessed by the federal government:

the risk profile for those is

just too high. * Today's real estate management

professionals are better educated,

more analytical and more accountable

than ever before. This is one of

the contributing factors to the stability

of the overall inventory. The

financial whiz kids who moved into

real estate in the late 1970s and

early 1980s to capitalize on tax benefits

without regard for underlying

economics got (or are getting) their

final comeuppance. (Along the way,

though, many made a great deal of

money at the expense of investors.) * Shrinkage is underway in the development

side of the business, as one

entrepreneur after another recognizes

the lower demand for new

construction in the 1990s. Some developers

are retiring; some are

switching to management of existing

assets; some are moving abroad;

some are focusing narrowly on

niche products; and some are moving

outside real estate to other

businesses. * Real estate lenders are becoming

more prudent about financing new

development. This change has only

occurred in the last few months, but

it is bringing private, commercial

construction almost to a halt, which

is exactly what is needed.

As suggested by these five trends, U.S. real estate as a whole is not in the dire straits that many reporters suggest. As an asset class, property investment is solid. The average returns on investment-grade properties are lower than they were 10 years ago. However, the risks have also been reduced significantly. One has to work harder to generate superior returns; but they can be achieved by redeveloping older properties for a new and higher use, by substantially upgrading and retenanting properties, by creatively adding rentable space to existing, high-quality buildings, and by acquiring underperforming assets and bringing them up to investment-grade standards. All of these activities have been Schroder Real Estate Associates' stock-in-trade for 15 years, and we believe it is one of the few real opportunity areas of the next three to five years.

The economic picture

The consensus view is that the U.S. will avoid a recession in 1990 - for the eighth year. However, growth will be slow, with an increase of only 1 percent to 2 percent in gross national product. Inflation is likely to remain about the same as in 1989 - 4.6 percent. Interest rates are not expected to fluctuate much, and long-term rates will be kept up by the higher rates in Japan and Germany. Nationally, unemployment is at 5.3 percent, and it will be kept down by the lack of growth in the labor force. The reduction in new entrants to the work force, which will persist throughout the decade, is generating a heightened focus on productivity gains among businesses of all types. Overall, that bodes well for future American competitiveness.

This sanguine expectation of modest, economic expansion masks some serious dislocations that are underway, both regionally and within industries. A few of them have implications for real estate investments. Specifically: * The financial services industry is

undergoing enormous change.

Thrift institutions lost their raison

d'etre with deregulation in the early

1980s, but it is taking 10 years for

their consolidation and transition

into banks. Commercial real estate

lending, in which they were minor

players until deregulation, proved to

be their undoing. Unfortunately,

American taxpayers will spend several

hundred billion dollars to

eliminate an industry that served

them well on the savings and home

mortgage front for nearly 50 years.

Although savings and loans are

being closed, merged and taken

over across the country, the greatest

impacts have been in the

southern states where the S&Ls

grew with the post-war population

and housing expansion. However,

the good news is that construction

lending has also stopped on the

strip retail centers, small office

buildings, business parks and apartments

that weren't needed in the

first place.

Investment banking firms are also

cutting back with the demise of aggressive

mergers and acquisitions

financed with junk bonds. These

cuts are most severe in New York,

but they also affect such other financial

centers as Los Angeles, San

Francisco, Chicago and Boston. The

clerical work forces are absorbed

quickly by other businesses because

of current labor shortages, so the

major impact is on the high-end

housing markets, which were fueled

by the purchasing patterns of highly-paid

young people in investment

banking. The stock market crash of

1987 signalled the end of double-digit

appreciation in New York's luxury

and upper-middle-income housing

market. Now the same is true in

Boston and Los Angeles.

So far, turmoil in financial services

has had little effect on Chicago,

which has benefitted from the resurgence

of Midwestern manufacturing

companies. However, Chicago's financial

exchanges are the seat of

program trading; and should that be

sharply curtailed, Chicago's office

market would suffer. * The Northeastern states are no

longer booming, and many claim

that they are in a recession. As

mentioned, the housing markets are

certainly depressed, but unemployment

levels are still so low that

many firms cannot hire the people

they need. Consequently, the difficulties

in financial services and the

Boston area's computer firms are

causing severe, short-term dislocations

but may prove to be helpful

overall because employees become

available to firms that would otherwise

be forced to relocate. (The

next area that may be brought up

short by a lack of labor is the Washington-Baltimore


We are optimistic about New

York, though the economy is likely

to be stable rather than booming

over the next several years. Just as

Los Angeles has flourished because

of trade with the Pacific Rim, New

York will benefit from the new focus

on European growth. Boston is a

much smaller market but from a

real estate standpoint, was being

treated as though it was four times

its actual size. Perspective is being

restored. * Texas is recovering - gradually. Oklahoma

and Colorado are still flat

and Louisiana remains severely

troubled; but Texas is on its way

back. Houston appears to be about

a year ahead of Dallas in its rebound,

which makes sense because

Houston went down first. Dallas's

economy remains the more diversified

and probably the stronger over

time, but Houston is working hard

to catch up.

The overhang of empty space in

Texas is still overwhelming and

should be evaluated with extreme

care by anyone deciding to reinvest

in Texas property. Contrary to the

belief of some opportunists who are

buying aggressively, it will be a long

time before quick bucks are once

again made in Texas real estate. In

Emerging Trends in Real Estate:

1990, Real Estate Research Corporation

points out: "The overall

supply of office space in metropolitan

Houston rivals the inventory of

space in Los Angeles (136 million

square feet) and Chicago (165 million

square feet) - markets with

almost double the population."

A steady stream of small-, medium- and

large-sized companies are

relocating to Texas - especially to

the Dallas area - and that trend will

continue. Availability of labor, low

housing costs, low office occupancy

costs and good air transportation to

the rest of the country will draw

more firms from high-cost/low-unemployment

cities. Access to

workers will be increasingly critical

through the 1990s. * Defense cutbacks will have to be

reckoned with in the early 1990s,

but few conclusions can yet be

drawn. In terms of defense contractors,

the greatest concentrations of

expenditures are in California, Massachusetts,

Connecticut, Maryland

and Virginia, all of which will undoubtedly

be hurt during the next

five years, though the degree cannot

be calculated.

Defense cutbacks will take the

heat off the Southern California

economy, but they will not be devastating

because of the size and

diversity of the area's activities. In

fact, more of the aerospace work in

Southern California may shift from

military to commercial production,

reducing the pressure in Seattle

where Boeing's order backlog for

commercial aircraft is enormous.

Military base closings will occur

throughout the country, and some

will have major impacts on surrounding

communities, especially

smaller population centers. It is reasonable

to expect the greatest cuts

to be in Army bases, followed by the

Air Force and then the Navy.

Although defense cuts appear inevitable,

they cannot occur rapidly;

so economic dislocations will be

stretched out over the next four to

eight years. * Less new money will be channeled

into property in 1990 because of the

negligible demand for new

construction. Mortgage lenders and

equity investors will avoid new development,

but both will remain

strongly interested in acquisition of

existing commercial projects, especially

large shopping centers,

industrial warehouses and light assembly

buildings and well-occupied

apartment complexes.

Although many U.S. pension

funds are postponing new allocations

to real estate, billions of

dollars committed in 1989 will be invested

this year. Furthermore, the

very large pension funds that invest

directly rather than through pooled

funds are still looking for solid existing

projects to acquire.

There is no shortage of buyers

for high-quality properties, and

prices will continue to rise for the

very best real estate. For mediocre

commercial buildings with poor current

returns, potential buyers are

not so plentiful and prices will be

soft in 1990. Pools of money are

being assembled with the intent of

buying properties repossessed from

savings and loans taken over by the

federal government. However, the

assumption is that bargains will be

available. So far, that has not been

the case because the government is

trying to avoid "dumping" properties.

Relatively few transactions will

occur until the government's staff is

in place and has had time to

straighten out title and other legal

problems and to assemble packages

for sale at prices low enough to enable

purchasers to "work out" the

real estate and still have a reasonable

expectation of sufficient profit

for the risks assumed.

Overall, 1990 will be an active year, like the last several, for investment-grade properties. Because fewer new developments are coming on stream, vacancy will be eroded and rents will generally hold steady. For the sub-investment-grade inventory, the focus will be on improving occupancy. Many properties that are losing money will finally be sold at prices that take into account the additional costs to reach a break-even point. When such properties are transferred to stronger owners, maintenance and leasing will improve. As mentioned earlier, most of the "bottom of the barrel" real estate will remain in government hands in 1990.

Shopping centers

Regional shopping centers, unlike other property types, were not over-built. Furthermore, as we have emphasized in prior years, they will not become overbuilt for three critical reasons: * It is extremely difficult to find 50 to

150 acres of vacant land, or land

able to be redeveloped in built-up

neighborhoods. (Retailers are no

longer willing to locate on the edge

of a metropolitan area and wait for

residential development to catch up

to them.) * Even if a site is found in an underserved

market, it is frequently

impossible to obtain zoning for a

major retail complex because residents

of established neighborhoods

object to the high traffic volumes

generated by shopping centers. * And finally, even with a zoned site,

developers have trouble attracting

anchor tenants. Most department

store chains are expanding slowly, if

at all. (This difficulty is currently

compounded by the fact that so

many of the quality chains are for


Fewer than 10 new regional malls are added each year, and most of those are in high-growth metropolitan areas where market demand is strong enough to support additional centers. Consequently, existing regional shopping centers generally have strong and growing franchises in their trade areas. This is recognized by investors, who buy the top regional malls at capitalization rates of 4.5 percent to 5.5 percent.

Only 13 percent of the new retail space created from 1982-1987 was in centers of more than 400,000 square feet. Because many of these large malls contained 1 to 1.5 million square feet, the 13 percent represents relatively few centers. In contrast, from 1967-1970, more than twice as much (29 percent) of the newly developed space was in centers of more than 400,000 square feet. And at that time, the typical new regional mall was under 750,000 square feet, so the higher proportion also covered a lot more shopping centers.

The proportion of new space represented by community-sized and large neighborhood shopping centers (100,000-399,000 square feet) also dropped, but not as dramatically. They constituted one-third of the space created in the mid-1980s, as compared to 45 percent in the late 1960s. Many of the recently-built community centers were in rural areas and small towns and were anchored by Wal-Mart, whose sales rose from $1.3 billion in 1979 to about $26 billion in 1989. Outside major metropolitan areas, both sites and zoning are much easier to obtain.

More than half the retail space added between 1982 and 1987 was in neighborhood and strip centers of under 100,000 square feet. This is the size category that is severely overbuilt through most of the U.S. - especially anchorless strip centers intended for six to twelve local tenants or franchisees. The federal government now has possession of many such centers.

In 1990 and through the decade, retail sales are expected to rise at about the rate of inflation. Some retailers will do far better than that by appealing to America's increasingly mature, affluent and discriminating buyers. Most of the 78 million "baby boomers" will be entering their highest earning years in the 1990s, and the majority of households have two wage earners, so disposable income will rise dramatically. Although that income does not have to be spent on retail goods, it will be available for well-targeted products. Many retailers are adapting quickly to an older buying public. The Limited is an excellent example. However, others are still confused by America's changing demographics. Without rapid adaptation, they will fade away.

Because retail sales are flat on an inflation-adjusted basis, rental increases in shopping centers are heavily dependent upon tenants' productivity improvements. Retailers are rapidly introducing computerized inventory controls tied to point-of-sale data systems, which enables manufacturers to make more frequent deliveries of goods that are selling and reduces retailers' inventories of slow-moving items.

To maximize income and maintain the draw of a shopping center, mall managers monitor the performance of their tenants, as well as the mix of goods being offered, the physical appeal of mall stores, the marketing approaches of individual tenants and the center as a whole. They also evaluate the operating costs that are being passed on to tenants.

Many of America's department store chains are currently for sale or are operating under the cloud of holding company bankruptcy. Although the short-term situation is troublesome, industry observers welcome the prospect of retailers once again assuming control of key national chains. Retailing is not a business for amateurs.

Office buildings

The good news on the office front is that new construction is down 35 percent from 1985's peak level. Even more encouraging is the prudent stance recently adopted by construction lenders: they have sharply curtailed new lending for office projects. The bad news, however, is that Coldwell Banker reports national metropolitan office vacancy at 20 percent at the end of 1989, up .3 points for the year. That is because 93.1 million square feet came on stream in 1989, but only 86.6 million square feet were absorbed.

Clearly, the U.S. needs several years of very low office construction to absorb the overhang. Office employment growth is much lower than it was 10 years ago, so it is likely to take four to five years to bring vacancy down to a workable 10 percent. Effective rents in most markets will not rise for at least three years.

The highest vacancy is still in suburban locations - a national average of 21.4 percent at the end of 1989. The figure for downtown office markets was 16.7 percent, up .5 percent percentage points over year-end 1988. There were actually 3.7 million more square feet completed in downtown areas in 1989 than the year before. The greatest additions were in the following locations: * Midtown Manhattan - 4.9 million

square feet. * Chicago - 4.1 million square feet * Washington, D.C. - 2.8 million

square feet * Seattle - 2 million square feet

According to Coldwell Banker, absorption was high in some of these cities, too - 4.6 million square feet in Midtown Manhattan, 2.8 million square feet in Washington, D.C. and 2.6 million square feet in Chicago. However, Chicago still has a great deal of new space under construction; vacancy will be rising there.

Of the 46 downtown office markets analyzed by Coldwell Banker, only four had year-end 1989 vacancy rates below 10 percent: * Honolulu - 3.7 percent * Charlotte, N.C. - 7.6 percent * Cleveland - 8.1 percent * Washington, D.C. - 9.1 percent

Among suburban markets, only Honolulu's vacancy was under 10 percent.

Despite the decidedly gloomy prospects for office markets across the country, prices are holding up well for investment-grade properties. As summarized by Landauer Associates, Inc., in their publication, 1990 Real Estate Market Forecast:

"The large pool of domestic and

international investment capital has

kept the price of first-class, central

city office towers at remarkably

high levels. This has been particularly

true in East Coast cities and

California. The most dramatic indication

of confidence, perhaps,

would be the $846 million purchase

of a 51 percent interest in the Rockefeller

Group by Mitsubishi Estate."

Industrial market

Industrial complexes are as popular as large shopping centers with today's institutional investors. The result is steadily rising prices for modern, fully tenanted, distribution warehouses and light assembly buildings. As Real Estate Research Corporation observes in its Emerging Trends report, "Capitalization rates for the most sought-after industrial properties are in the range of 6.5 percent to 7.5 percent and are edging down....This is the only U.S. property type that sells at lower cap rates than its counterparts in other world markets." At the same time, though, industrial space is generally rented on a triple net basis, so cost escalations are passed directly to the tenants and management expenses are low.

Furthermore, industrial development has not exhibited the speculative fever of other land uses. Vacancy has averaged 5 percent to 7.5 percent nationally for years, and it is expected to drop to the lower end of this range in the early 1990s. There is always a danger that more developers will move into industrial construction because of lack of demand for other uses, but this has not been a serious problem to date. In fact, construction from 1983-1989 was very steady - in a range of 115 to 130 million square feet annually. A high proportion of new industrial projects are actually built to suit specific users. About 45 percent of the buildings in the national inventory are owner-occupied, and nearly three-fourths are occupied by single tenants.

This is one land use where demand is expected to exceed supply in the early 1990s. Because of the slow growth anticipated for the U.S. economy this year, demand for industrial space is not expected to pick up until 1991.

America's commercial industrial inventory (excluding large, special purpose facilities like refineries, steel mills, aerospace manufacturers, etc.) principally encompasses manufacturing and warehousing activities. Each accounts for just over two-fifths of the inventory. Only 6.4 percent of the space is devoted to research and development activities, which is just as well because this is the one type of industrial property that is overbuilt in most parts of the country. Also, one-third of U.S. research and development spending is defense-related, and that funding is likely to decline in the 1990s.

Warehousing and manufacturing activities are carried out virtually everywhere in America. In terms of future industrial demand, though, the Western region will be the strongest, followed by the South, the Midwest and the Northeast. According to David Birch of MIT, Los Angeles will be the single most active market, where the greatest demand will be for bulk distribution and Flex/R&D space. The second largest market will be New York, where both replacement demand and new activities will require traditional manufacturing space as well as warehouses. Landauer Associates identify the following 10 markets as most attractive for warehousing and distribution activities (in order of priority): Dallas, Seattle, Miami, Oklahoma City, Charlotte, North Carolina, Phoenix, Atlanta, Chicago, Birmingham and Houston.

Half of these are coastal cities, and eight out of the ten are in the Sunbelt. Although the traditionally strong industrial Midwest is only represented by Chicago, Landauer's second tier of ten cities includes six in the Midwest.

Just to demonstrate the breadth of opportunity in industrial investment, Coldwell Banker cites 10 different markets, each of which is believed to have a demand level representing 3 percent or more of the current space volume: Ft. Lauderdale, Riverside, California, Las Vegas, West Palm Beach, Jacksonville, Florida, Sacramento, Orlando, San Diego, Oxnard, California and Norfolk, Virginia.

Industrial real estate is obviously doing just fine, and the positive trends are widely expected to accelerate in the 1990s. Furthermore, this is a market that entails billions of square feet. Yet time after time, the media never mentions industrial property in their analyses of U.S. real estate.

1990 opportunities

For straight purchase of investment-grade real estate, the two property types that are not overbuilt are clearly regional shopping centers and industrial warehouses and manufacturing facilities. Community shopping centers anchored by strong discounters are also good candidates, particularly because the capitalization rates are 2 to 3 percentage points above those of regional malls. However, location is especially critical for community centers: one has to be wary about future intercepting competition.

Although not discussed here, existing and well-occupied apartment complexes can also be very solid investments. The syndicator-driven construction of the early 1980s is over, and vacancy is slowly moving downward. More importantly, rents have firmed in many markets and are beginning to move up. (For the most part, non-economic apartment development stopped in 1986, so there have been nearly four years of absorption in the southern and central U.S. markets that were so badly overbuilt.)

Schroder Real Estate Associates' traditional niche markets are still very attractive: acquisition of regional shopping centers with upgrading/expansion potential, and opportunistic purchase of well-located but under-performing office buildings. Although it is not easy to find appropriate malls with value-enhancement potential, a few come to market each year and others can be purchased on a joint venture basis with existing owners.

The office market holds considerable opportunity now that the volume of new construction is tapering off. Many owners have been funding shortfalls with the expectation that leases would roll over at higher rents. Now they see that the same deep concessions have to be given to renewing tenants. Therefore, some of these owners are prepared to sell at realistic prices - or are turning properties over to lenders who, in turn, find that the sales price is below the mortgage amount. For well-built office buildings in good locations, acquisitions at reasonable prices can be attractive.

A final area of considerable potential is recreational residential development - second homes. This is not generally an institutional investment category, though the Japanese are extremely interested in golf course resorts. The demographic profile of the 1990s, with large numbers of working but older households, portends strong demand for second homes and "getaway" resorts. The most appealing second homes will be within two to two-and-a-half hours driving time of primary residences - so that they can be used frequently on weekends and not just for vacations.

As mentioned earlier, the American real estate market is not in the dire condition being portrayed in many press reports. Quite the contrary. After five years of irrationally persistent development, particularly of office buildings, both lenders and developers have finally curtailed their enthusiasm. So reason has returned. Furthermore, all property types were not overbuilt, as the discussions of regional shopping centers and industrial manufacturing and warehouse buildings reveal.

Most institutional portfolios are weighed down with office buildings, so performance has been hurt by high vacancy and low rents. For those investors focused on retail, industrial or apartments, returns have generally been attractive - and will continue to be so.

Leanne Lachman is managing director of Schroder Real Estate Associates, New York City.
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Title Annotation:real estate industry in 1990 and beyond
Author:Lachman, Leanne
Publication:Mortgage Banking
Date:Jul 1, 1990
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